A long-running theme of this blog has been the impact of Quantitative Easing (and its tapering) on the world. Then, back in November, Janet Yellen’s departing gift to us was the announcement of the unwinding of the Fed Balance Sheet. At the time, instead of writing a post about it, my friend Andy and I recorded a podcast episode about the impacts of QE, QE tapering, and the potential roadmap for the QE unwinding. You can listen to it here:
At the time, Janet suggested that unwinding the balance sheet at a rate of USD 10 billion per month would be like “watching paint dry”.
My thought is “We can only hope it’s that boring”.
This post will (hopefully) explain why it may not be.
The original QE Chain of Events
A brief recap: Quantitative Easing essentially meant that the Federal Reserve was flooding the market with cash. How this worked:
- The story begins with:
- An investor, who has carefully invested $1 million in a US treasury bond, on the advice of his financial advisors;
- The Federal Reserve, who is concerned that the bond investor is being too conservative with his money during this time of crisis.
- So the Federal Reserve says to the investor “Let me buy that $1 million US treasury bond from you. I’ll pay you full market price. Also, btw, I plan to buy plenty of these, regularly, for all the forseeable future.”
- At this point, the financial advisors turn to the investor, and say “Listen, you’d better sell it. The news that that the Fed is buying up the bond market has circulated, and bond prices are now extremely high. The interest yield is almost negligible – and we’re really not sure what is going to happen as a result of all this. You’d be better off putting your money into something that offers an actual potential return. Like gold. Or even emerging market equities, or something like that. Hell, it’s all risky right now. May as well get paid for it.”
- So the sale happens:
- The investor now holds cash;
- The Federal Reserve now holds a US treasury bond as an asset, and a ‘liability’ in the form of the cash that it just issued to the investor.
The point here is that two ‘conditions’ were emerging concurrently:
- The Fed was pushing lots of ‘cheap’ money into the market (it lowered the interest rates/yields across the board); AND
- The Fed was effectively carving out asset classes from the universe of potential investments, and thereby forcing investors to put their cheap money into a more limited range of assets. And this was happening just after a chunk of investable assets took a massive knock and/or disappeared in the financial crisis of 2007/2008 (real estate, mortgage-backed securities, CDOs, etc).
So the cheap money combined with the asset shortage to drive a wave of asset price inflation: in stock markets, emerging markets, non-US bonds, and so on.
Here’s a picture:
The QE tapering chain of events
When the QE programs ended, this meant that:
- The flow of cheap money was turned off; but
- All those carved-out asset classes were still sitting in the same place: inaccessible, on the Federal Reserve balance sheet.
So the asset price inflation slowed, but that’s about it. Here’s another way to think about it:
- Cheap money increased the demand for assets to invest in;
- The asset-purchasing program decreased the supply of investable assets (as had the events of the financial crisis).
- That excess demand and that supply shortage forced up asset prices.
- But if you just ‘stop’ the flow of cheap money, it’s not like the money suddenly disappears. It’s all still there, still fighting over the still-limited supply of investable assets. It may shift in its allocation between certain asset classes – but even that is somewhat limited by the fact that there are not enough assets to go round.
And let’s not forget that the Federal Reserve continued to purchase assets to replace any of the assets in its portfolio that were maturing. It kept its balance sheet constant.
Over time, you’d expect asset classes to step up to absorb some of that supply shortage. And we did see that: cryptocurrencies, new stock market listings, fresh bond raises from emerging markets. But the volatility in the ‘better assets’ (like US stock markets) was still low – because (I guess) those became the higher tier of capital in this new post-QE world.
The reversal of the asset-purchasing program
So the question is: what happens now that the Federal Reserve has committed itself to releasing some of those quarantined asset classes to the world?
Especially now that the Fed is on a rate-heightening cycle.
- The flow of cheap money is going into reverse; and
- The universe of investable assets is expanding. Slowly, perhaps. But expanding nonetheless.
And we live in a time where the smallest news events are taken by algorithmic traders, and spun into market movements.
Here’s a picture of the Fed balance sheet for the last year:
Is it really that surprising, then, that there has been a sudden panic in the markets, and a spike in the amount of volatility?
We should expect more of it.
The QE bubble is being deliberately deflated: even if it’s less of a pop, and more of a slow leak.
Rolling Alpha posts opinions on finance, economics, and sometimes things that are only loosely related. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha. Also, check out the RA podcast on iTunes: The Story of Money.